The real balance effect: Shortcomings

Abstract

Why does wage restraint not increase domestic demand, as proclaimed in the SICCD models? In this chapter, I will argue that the real balance effect which is at the heart of the above models may not work as assumed. Falling prices do not necessarily and automatically increase aggregate domestic demand, as the real balance effect proclaims. It is not a coincidence that the real balance effect does not work: I will show that, for institutional and theoretical reasons, it cannot play a significant role in a world of modern central banking as we know it from the euro-zone, post-war Germany or the USA.